Shifting the odds in your favor

By Mark Knodel

Have you ever been to a casino and played roulette? The casinos don’t beat the players because they get lucky, they beat the players because the odds are stacked in their favor. This built-in advantage is called the house edge. As an example, in roulette house edge is about 5% according to VegasClick.com. That means for every dollar bet, the casino keeps 5¢ as profit, and returns the other 95¢ to the players as winnings, on average. So, if the casino takes only a 5% profit on roulette, why do most players lose 100% of their money? It’s because the house edge applies to the amount you bet, not the amount you take to the casino.

Let’s say you sit down at a roulette table with $100, and bet $5 a spin. You’re betting about $150/hr., even though you brought only $100 with you. That’s because you win some rounds as you play, and you’re betting from your winnings. After 13 hours of play (if you last that long), you’ve bet $1,950 – And 5% of $1,950 is $97.50, almost your full $100. In other words, the casino makes money over time because the odds are in their favor.

What if you took the same concept to the financial markets? How would you go about shifting the odds to your favor? One way that that may allow you to accomplish this (historically) is following the 10 Month Moving Average (10 MMA) of an asset class.

This chart shows five asset classes and what took place when these asset classes were trading above and below their respective 10 MMA for a 36 year period from 1973-2008. It makes the point that when an asset class is trading above its 10 MMA (around 70% of the time), its annualized return is higher and the annualized volatility is lower than when it is trading below its 10MMA. To further explain:

Take a look at U.S. Stocks and the numbers circled in green and red. The green circles are saying that over the sample period 1973-2008 (36 yrs.), US Stocks traded above their 10 MMA about 73% of the time. When U.S. Stocks traded above their 10 MMA, their annual return was about 13.5%. Lastly, their volatility (the relative rate at which the price of a security moves up and down) was measured at 13.89. Now compare the green circled numbers to the red circled numbers that are stats for when US Stocks traded below their 10 MMA. So, you can easily see that when U.S. Stocks traded above their 10 MMA, annual returns were about 78% better and almost 40% less volatile than when they are trading below their 10 MMA. You can see similar results for U.S. Stocks for over 100 years at the bottom of the chart.

This chart is not saying that asset classes can’t go up when they are trading below their 10 MMA or go down when trading above their 10 MMA. But, it does suggest that the historical odds of making higher returns with less volatility are present when an asset class is trading above its 10 MMA over time. After looking closely at this cart, why would you invest in a diversified portfolio of U.S. Stocks when they are trading below their 10 MMA to get 2%-3% annually while enduring much higher volatility? My suggestion is to either move money to an alternative asset class or to cash alternatives to help preserve assets when an asset class is trading below its 10 MMA.

Casinos make it clear that you win over time when the odds are in your favor. The key words are: over time. Following the 10 MMA of various asset classes may help you accomplish (over time) what the casinos have already figured out.

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